The odds of a policy error are increasing, especially when everyone seems to be over-extrapolating COVID distortions into a new secular inflation narrative and when central banks are channeling the virtues of Paul Volcker (or, in Europe, the ’70s Bundesbank). What we need is a “growth scare,” one that is sufficient to stop central banks freaking out but not large enough to plunge the world into recession. And with all parts of the world facing near-term problems, this scare is now a distinct possibility. Combine China’s property slump (and lockdowns) with a massive squeeze on real incomes in Europe, plus tighter financial conditions in the U.S., and perhaps the world economy will deteriorate just enough to put the authorities on a more cautious policy path. In fact, this “soft patch” may be our best chance right now of a “soft landing.”
It’s apt that we are now in the position of looking for help from disasters around the world. And it will be no small feat if the Fed can pull it off. The following chart from the foreign exchange team at Commerzbank NA defines a soft landing as an episode in which the the fed funds rate is raised without prompting a recession. Three-quarters of hiking campaigns end in one. The last soft landing came in 1994—and many would complain that the Alan Greenspan Fed on that occasion sparked a recession in Latin America and the rest of the emerging markets, even if one was avoided in the U.S.:
It’s just possible that the motley forces of Covid-zero, China Evergrande Group and Vladimir Putin could somehow allow the FOMC to bring the airliner of the U.S. and global economy safely to rest on the Hudson River. Not likely, but there’s a chance.
What Is A Real Rate, Anyway?
The Fed wants to tighten financial conditions, and that’s best measured by the real interest rate—the baseline rates that are payable after inflation. The problem: How do you measure those real rates, and are the markets judgments trustworthy?
There is a direct way to measure them in the economies that offer inflation-linked bonds. The problem is that those markets may not be efficient enough to trust. Dhaval Joshi of BCA Research puts it as follows:
Using the real yield on inflation-protected bonds as a gauge of the long-term real interest rate is possibly the biggest mistake in finance. The ultra-low real yield on inflation protected bonds captures nothing more than a stampede for inflation protection overwhelming a tiny supply of inflation-protected bonds.
Beyond that, Joshi also points out that the TIPS market tends to be swamped by the far bigger market for crude oil. Inflation-linked bonds tend to be used as a hedge by oil traders, which is a problem because this means that real yields tend to follow oil prices. As near-term rises in the oil price should all else equal reduce long-run inflation (by increasing the base), the relationship between the two should be inverse. In fact, they move together—when the oil price goes up so the price of TIPS rises compared to fixed income:
Joshi therefore suggests that the TIPS yield is best ignored. And there is evidence that it is indeed ignored. If the real rate really mattered more than the nominal rate for investments, and economic theory dictates that it should, then we should expect to see a stronger relationship between real rates and subsequent returns on stocks than between nominal rates and stocks. Experience over the last 15 years emphatically suggests that this is not the case.
Dec Mullarkey, managing director of SLC Management, offered these scatter plots showing the relationship between changes in different fixed income variables and changes in equities. The trend line for real rates is an almost perfectly straight line—in other words, there’s no relationship at all. There is a discernible relationship with nominal bond yields—as yields rise, so equities can be expected to rise. The strongest relationship is with inflation expectations, derived from the yields on TIPS. The more inflation expectations are rising, the better the returns for equities will be: